Oil and Speculation

Paul Krugman says that either the price of a storable commodity can be determined by supply-and-demand on the spot market, with no stored reserves held off the market for speculative purposes:

Or the price can be determined by speculators, with them holding enough of the commodity off the market in their speculative inventory in order to drive the current spot price up to a level where it no longer pays for speculators to take even more of the current supply off the market:

In which case the current and the futures price of the commodity should be in contango: the future price should be higher than the current price by the cost of storage plus the interest rate. Since we don't see either large inventories of tanker cars filled with oil on the sidings or futures prices for oil above spot prices to make storing marginally profitable, he concludes that speculation is not driving oil prices today:

http://www.princeton.edu/~pkrugman/Speculation%20and%20Signatures.pdf [H]ere’s the thing: the actual data we have on crude oil don’t show the signatures of a market driven by speculative demand. Inventory data don’t show a big accumulation; and the market has mostly been in backwardation, not contango. It made news when, late last month, a slight contango developed – because until then there had been backwardation. Maybe I’m misinterpreting what the advocates of a speculative story are thinking. But in that case, what are they thinking? I’m curious.

And:

Various notes on speculation: Right now I see well-trained economists getting caught up in an equivalent fallacy — the doctrine of immaculate hoarding? — because they’re getting hung up on the financial relationships between spot and futures. Whatever you say about the futures market, it can only drive up the spot price by causing physical hoarding of physical goods.... [S]ome readers have asked me why my inventory argument didn’t apply to the housing bubble. The answer is that a house is a durable good, which unlike oil, which you have to burn, isn’t used up by the consumer; what we consume are housing services — in effect, consumers rent houses, from themselves if they happen to be homeowners. To see the equivalent in housing of what the oil bubble types think they’re seeing in oil, we’d have to have seen a sharp rise in rental rates. It didn’t happen....

Third, some people have asked what I said about the California energy crisis of 2000-2001, perhaps history’s greatest example of market manipulation.... During that whole period, I was pretty much the only voice in a major news outlet even suggesting that market manipulation might be a central factor. And here’s the thing: I applied pretty much the same reasoning to that crisis that I’m applying now. The only way market manipulators could have been driving up prices was by keeping physical supply off the market. And they were in fact doing just that: there was huge unused generating capacity, consistent with the idea of deliberate withholding. Some years later we would actually get hold of control room tapes in which Enron traders called plants and told them to shut down, and boasted about cutting off Grandma Millie’s power.

I’m still waiting for evidence that physical withholding is going on in the oil market.

abandonment of the silly idea that price jumps in oil or food are the result of wicked “speculation” – a fantasy promoted by dangerous populists across the globe.

Hmm. Who are these “dangerous populists”? Well, elsewhere in the FT there’s an article titled “U.S. senator seeks clampdown on speculation in oil markets”, which quotes Joe Lieberman saying that speculators are a:

significant contributing factor to the economic distress now being felt by American consumers every time they stand in the grocery store checkout line or pay for a fill-up at the gas pump

Joe Lieberman, the Huey Long of Greenwich! And let’s not forget those wild-eyed, shaggy-haired leftists at National Review, who have been telling us that high oil prices are a bubble that’s about to burst for more than 5 years. By the way, the FT article on Lieberman mentions that

Some observers say lawmakers have not explained how speculators or pension funds are boosting prices or why the prices of raw materials such as iron ore, rice or coal - in which speculators have limited access - are also booming.

I’m delighted at the promotion. I used to be one of Those Who; now I’m Some Observer...

And:

Confusions about speculation: I’m asking whether expectations of a higher future price and/or investment in the futures market by institutional investors are pushing up the current price. If the answer is yes, then we can ask whether there’s a bubble — that is, whether the expected future price is unreasonable. It’s quite possible to have speculation that isn’t a bubble.... [B]ut is speculation, rational or not, driving the price of crude?

Basically, it’s hard to reconcile the view that it is with two facts: for most of the recent runup, inventories were static or declining and the futures market was in backwardation, not contango. (Can the futures market pull up the spot price when the futures price is less than the spot price?)

OK, you can offer excuses. Maybe the oil inventories are being held in the ground; but do we have any evidence that oil producing countries are withholding output? (And for those who blame speculators, are Kuwait and Saudi on the other side of those futures contracts?) Maybe there’s a shifting liquidity premium that mucks up the relationship between spot and future. But this really is starting to sound like epicycles — an attempt to rescue the speculation hypothesis, which originally was supposed to be based on compelling evidence, by saying that there’s actually no evidence that could refute it...

Comments

Paul Krugman says that either the price of a storable commodity can be determined by supply-and-demand on the spot market, with no stored reserves held off the market for speculative purposes:

Or the price can be determined by speculators, with them holding enough of the commodity off the market in their speculative inventory in order to drive the current spot price up to a level where it no longer pays for speculators to take even more of the current supply off the market:

In which case the current and the futures price of the commodity should be in contango: the future price should be higher than the current price by the cost of storage plus the interest rate. Since we don't see either large inventories of tanker cars filled with oil on the sidings or futures prices for oil above spot prices to make storing marginally profitable, he concludes that speculation is not driving oil prices today:

http://www.princeton.edu/~pkrugman/Speculation%20and%20Signatures.pdf [H]ere’s the thing: the actual data we have on crude oil don’t show the signatures of a market driven by speculative demand. Inventory data don’t show a big accumulation; and the market has mostly been in backwardation, not contango. It made news when, late last month, a slight contango developed – because until then there had been backwardation. Maybe I’m misinterpreting what the advocates of a speculative story are thinking. But in that case, what are they thinking? I’m curious.

And:

Various notes on speculation: Right now I see well-trained economists getting caught up in an equivalent fallacy — the doctrine of immaculate hoarding? — because they’re getting hung up on the financial relationships between spot and futures. Whatever you say about the futures market, it can only drive up the spot price by causing physical hoarding of physical goods.... [S]ome readers have asked me why my inventory argument didn’t apply to the housing bubble. The answer is that a house is a durable good, which unlike oil, which you have to burn, isn’t used up by the consumer; what we consume are housing services — in effect, consumers rent houses, from themselves if they happen to be homeowners. To see the equivalent in housing of what the oil bubble types think they’re seeing in oil, we’d have to have seen a sharp rise in rental rates. It didn’t happen....

Third, some people have asked what I said about the California energy crisis of 2000-2001, perhaps history’s greatest example of market manipulation.... During that whole period, I was pretty much the only voice in a major news outlet even suggesting that market manipulation might be a central factor. And here’s the thing: I applied pretty much the same reasoning to that crisis that I’m applying now. The only way market manipulators could have been driving up prices was by keeping physical supply off the market. And they were in fact doing just that: there was huge unused generating capacity, consistent with the idea of deliberate withholding. Some years later we would actually get hold of control room tapes in which Enron traders called plants and told them to shut down, and boasted about cutting off Grandma Millie’s power.

I’m still waiting for evidence that physical withholding is going on in the oil market.

abandonment of the silly idea that price jumps in oil or food are the result of wicked “speculation” – a fantasy promoted by dangerous populists across the globe.

Hmm. Who are these “dangerous populists”? Well, elsewhere in the FT there’s an article titled “U.S. senator seeks clampdown on speculation in oil markets”, which quotes Joe Lieberman saying that speculators are a:

significant contributing factor to the economic distress now being felt by American consumers every time they stand in the grocery store checkout line or pay for a fill-up at the gas pump

Joe Lieberman, the Huey Long of Greenwich! And let’s not forget those wild-eyed, shaggy-haired leftists at National Review, who have been telling us that high oil prices are a bubble that’s about to burst for more than 5 years. By the way, the FT article on Lieberman mentions that

Some observers say lawmakers have not explained how speculators or pension funds are boosting prices or why the prices of raw materials such as iron ore, rice or coal - in which speculators have limited access - are also booming.

I’m delighted at the promotion. I used to be one of Those Who; now I’m Some Observer...

And:

Confusions about speculation: I’m asking whether expectations of a higher future price and/or investment in the futures market by institutional investors are pushing up the current price. If the answer is yes, then we can ask whether there’s a bubble — that is, whether the expected future price is unreasonable. It’s quite possible to have speculation that isn’t a bubble.... [B]ut is speculation, rational or not, driving the price of crude?

Basically, it’s hard to reconcile the view that it is with two facts: for most of the recent runup, inventories were static or declining and the futures market was in backwardation, not contango. (Can the futures market pull up the spot price when the futures price is less than the spot price?)

OK, you can offer excuses. Maybe the oil inventories are being held in the ground; but do we have any evidence that oil producing countries are withholding output? (And for those who blame speculators, are Kuwait and Saudi on the other side of those futures contracts?) Maybe there’s a shifting liquidity premium that mucks up the relationship between spot and future. But this really is starting to sound like epicycles — an attempt to rescue the speculation hypothesis, which originally was supposed to be based on compelling evidence, by saying that there’s actually no evidence that could refute it...